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May 2, 2013

One Major Reason to Include Real Assets in a Portfolio

They can do wonders for inflation protection, argues Capital Innovation’s Underhill

Michael Underhill, chief investment officer of Milwaukee-based Capital Innovations, argued Tuesday at IMCA’s annual conference in Seattle for more real assets in the investment portfolio. The reason, as one might expect, was to combat the effects of inflation.

“Even low to moderate inflation can dramatically impact participants’ purchasing power over time,” Underhill said. “For example, a 2% annual inflation means that a dollar today will only have the purchasing power of 55 cents 30 years from now.”

He added that defined contribution plan investors must manage a real liability—their own expenses in retirement.

“The objective of a defined contribution plan is to generate cash flow in retirement. If the inflation-adjusted value of a plan participant’s savings falls significantly; they have to make some hard choices around how to reduce their levels of spending.”

In order to protect retirees from significant erosion in purchasing power, it is useful to include investments that mitigate the impact of inflation. Hence, his call to include real assets.

“Unexpected inflation is a change in prices that differs from the consensus view of what inflation is expected to be,” Underhill explained. “When we talk about inflation risk, we are commonly talking about unexpected inflation.”

While expected inflation must be planned for in retirement budgeting, unexpected inflation causes uncertainty in prices because it represents a surprise to the market. Since it cannot be predicted, he noted, managing the risk of unexpected inflation is critical.

“A real assets strategy should comprise tangible real asset classes, whose values are driven by barriers to supply and rising replacement costs. Inflation-linked assets like agribusiness, timber and infrastructure produce a higher return when inflation rises and help provide unique attributes that contribute to an investment portfolio's overall diversification and income needs while providing for a much-needed inflation hedge. “

He added that recent market turbulence had many participants worried about their retirement savings. Sponsors want to help but don’t want to overwhelm participants with too many choices.

“They also want to help participants effectively diversify to manage for inflation, weather volatile stock and bond markets and ultimately achieve the lives they want in retirement. Nontraditional asset classes may help sponsors and participants achieve some or all of these goals.”

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